A deferred tax liability arises when a company's real-world tax bill is lower than what its financial statements suggest it should be due to differences between tax accounting rules and standard accounting practices. The liability signals to observers that the company remains under a tax obligation.

Dual Accounting

The tax code allows companies to essentially keep two sets of books: one for their regular financial accounting -- their internal bookkeeping and the financial statements they make available to investors, regulators and the public -- and one for their income taxes. This is because standard accounting rules and the tax code differ in key areas such as revenue and expense recognition and asset depreciation. In their regular accounting, companies aim to maximize the profits they can show to shareholders. In their tax accounting, though, they benefit by pushing profits into the future, reducing their tax burden now and allowing them to invest money rather than pay it to the government. This dual accounting is legal as long as a company is shifting its responsibilities among years rather than illegally evading them.

Deferred Tax Liabilities

Simply put, a deferred tax liability represents taxes that a company would have had to pay under its regular financial accounting but that it has deferred to the future by way of the tax code. Imagine that your company could report $5,000 in profit either this year or next year and that whenever it reports that profit, it will pay a tax of 30 percent. In your tax accounting, you push that profit into next year, freeing up $1,500 for investment rather than paying taxes. In your financial statements, you report the $5,000 profit upfront. But since the company doesn't actually pay taxes on that money, its balance sheet must show that $1,500 in future cash is now "spoken for." It does that by creating a $1,500 deferred tax liability.

Depreciation Example

The most common source of deferred tax liabilities is depreciation, the process by which companies allocate the cost of assets. Say that your company spends $6,000 on a machine that will last three years and that it pays a 30 percent tax on profits. Under regular financial accounting, you depreciate the machine by $2,000 per year for the next three years. Each year, your company's financial statements (but not necessarily its tax returns) show a reduction in net income of $2,000 and a $600 reduction in taxes. Now say tax accounting allows your company to front load the depreciation so the company depreciates $3,000 in the first year, $2,000 in the second and $1,000 in the third. In the first year, the company claims $3,000 in depreciation expense on its tax return, reducing its taxes by $900. It creates a $300 deferred tax liability on its balance sheet to represent the difference between what it "should" have paid based on its financial statements and what it actually paid. In the third year, the situation reverses itself. The company pays $300 more in taxes than what the financial statements show it "should." The company handles the difference by eliminating the liability from the balance sheet.

Understanding the Concept

It can be helpful to think of a deferred tax liability as the amount by which a company has "underpaid" its taxes in the past, an amount that will have to be made up in the future. But it's important to understand that the company didn't actually underpay. The company completely fulfilled its tax obligations; it just recognized those obligations in its financial accounting on a different timetable than when it paid them in its tax accounting.